Earn-Out: A Strategically Advantageous Tool for Your M&A Transactions.

The valuation of the target company is the most crucial negotiation point in an M&A transaction and can slow down the process in case of disagreement. To mitigate this risk, stakeholders sometimes resort to the earn-out to overcome valuation differences and align their interests.

In recent years, the earn-out has been increasingly used, linked to the widespread adoption of the model.

This article examines the advantages of the earn-out and its role in facilitating negotiations between sellers and buyers, particularly by reducing risks for the buyer, motivating the seller to achieve performance targets, and offering flexibility in the evaluation of the company.

A. The Earn-Out: An Essential Clause for Your Transactions

The earn-out, or “price supplement” in French, is a contractual clause stipulating the deferred payment of a portion of the sale price, contingent upon the future performance of the company. Performance criteria, such as revenue, net profit, EBITDA, or a combination of several aggregates, are defined for a specific period following the completion of the transaction.

This mechanism facilitates negotiations when the seller tends to overestimate the sale price and the buyer underestimates it. Thus, the sale price is divided into a fixed amount, paid upfront, and a variable amount based on the company’s future results and defined objectives. The better the results, the higher the price supplement. It is crucial that the criteria for determining this price supplement are objective, to avoid nullifying the sale and ensuring the clause’s compliance with French law. It is also recommended to opt for a simple structure of performance criteria to shorten discussions.

The earn-out is thus a true win-win tool:

  • The seller can increase their sale price;
  • The buyer benefits from the seller’s expertise during all or part of the earn-out period and reduces risks.

However, it is essential to consider the human factor in an earn-out. The seller will work with the buyer, and it is important that both parties share the same vision for the company’s development and maintain regular communication.

B. The Advantages of the Earn-Out

  1. Reduction of Valuation Discrepancies: The earn-out bridges the valuation gap between the parties by linking part of the sale price to the company’s future performance.
  2. Consideration of External and Variable Factors: The earn-out reduces risks for the buyer entering a new market and allows the seller to benefit from the company’s future growth.
  3. Motivation and Alignment of Interests: An earn-out clause encourages the seller, often still involved post-acquisition, to stay motivated to meet set objectives. This aligns the interests of the seller and buyer, thus enhancing the company’s optimal performance.
  4. Facilitation of Negotiations: By offering a lower initial payment but with future payments conditional on performance, the parties can more easily find common ground, making discussions less contentious.
  5. Flexibility and Adaptability: The earn-out allows the structuring of the operation to be tailored to the specifics of each transaction and the needs of the stakeholders.

C. The Essentials of a Precise Structuring for a Successful Earn-Out

  1. Performance Criteria (Financial and Non-Financial): The criteria for an earn-out must be precise, measurable, and realistic, and accepted by both parties to avoid conflicts. The choice of aggregates, underlying the earn-out, serves as an alignment tool between the seller and the buyer.
  2. Duration of the Earn-Out Period: The period during which performance will be evaluated must be clearly defined. It generally ranges from one to three years.
  3. Methods of Calculating Earn-Out Payments: The formula for calculating the earn-out amount must be transparent and detailed, including potential adjustments for extraordinary events.
  4. Implementation of Monthly Monitoring on the Earn-Out Underlying: This allows for communication spaces to prevent disputes.
  5. Conflict Resolution Mechanisms: Procedures to resolve disputes should be established, such as arbitration or mediation, to manage disagreements that may arise regarding performance evaluation.

D. Accompaniment by Your M&A Advisor and Business Lawyer for Proper Implementation of Your Earn-Out

  1. Complexity of Base Price Determination and Duration, and Litigation Risks: To avoid litigation related to the evaluation of future performance, objective and precise performance criteria are essential. The expertise of an experienced advisor is crucial to model the earn-out and clarify the agreement’s terms, including the base price determination and the seller’s support duration.
  2. Difficulty of Implementation of Monitoring: Rigorous monitoring and monthly communication are necessary to ensure that performance criteria are met and that payments are/will be correctly calculated. Clear structuring and a detailed monitoring plan are indispensable for effective management of the earn-out.
  3. Uncertainty for the Seller: A competent advisor can alleviate this stress by evaluating future prospects and structuring the earn-out to protect the seller’s interests.

In a nutshell:

At OutMatch, we are trusted partners specializing in supporting our clients in their M&A transactions. We provide expertise, creativity, a drive to succeed, and innovative solutions to advise you and help you make the best decision for your company.

To discuss your M&A thoughts and value creation, feel free to email me at: maxime.nicolas@outmatch.fr

 

 

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